Why It's Game On for Nvidia

| About: NVIDIA Corporation (NVDA)

They say you can't make an omelet without breaking a few eggs, and, that's exactly what Nvidia (NASDAQ:NVDA) did on May 9 when it announced it is buying Icera, a producer of baseband processors. With the acquisition, Nvidia expands on its core competency of GPUs (graphics processing units), and is essentially throwing down the gauntlet, and climbing into the ring with wireless industry heavyweights Broadcom (BRCM) and Qualcomm (NASDAQ:QCOM).

Because of the consolidation of not only the semiconductor industry, but of chips themselves (think Moore's Law: The number of transistors that can be placed inexpensively on an integrated circuit doubles approximately every two years), Nvidia felt it was a move it had to make to be viable in the future. According to Nvidia's latest conference call:

"Icera is the pioneer in next-generation wireless modem technologies called software-defined radio or SDR technology. They have created ultra-low power, high performance processors, specifically, specially designed for processing multiple modem protocols."

What does all this mean in English? It means that wireless devices using the chips will work on LTE, 2G, 3G, 4G and Wi-Fi networks. And as Matthew Murray reports in PCMag.com in his article "Nvidia to Acquire Baseband Processor Developer Icera:"

"This lets manufacturers develop for multiple products from a single platform, while reducing development costs and times and enabling easier support for future standards."

Not only will consumers and manufacturers benefit from this product, but Nvidia probably will, too.

Although the market for baseband processors is one of the fastest growing segments of the technology sector at an estimate of $15 billion a year, you need to consider some issues with Nvidia before you go out and purchase its shares. As CEO Jen-Hsun Huang said in the conference call referring to the Icera deal, "we expect the acquisition to be slightly dilutive for the remaining part of the year." According to Yahoo Finance, out of the 32 analysts covering the stock, 20 have a hold on it and that tells you something right there. Let's take a look and see what this hesitancy is all about.

Nvidia as a company has always had good body language, a little swagger in its walk because of its impressive heritage. Barrons scribe Jay Palmer in his 1/22/11, article "The Next Picture Show: says:

"The company invented the chip that produces computer graphics and, despite some intense competition, still dominates the fast growing graphics-processing business.". Nvidia's chips are the defacto standard on most personal computers and notebooks, and, according to a 5/10/11 CitiGroup (NYSE:C) research report by Glen Yeung, "85% of revenues (are) derived from the PC and workstation market."

Dominating a market is one thing. Dominating a market with minuscule growth is another. Aaron Ricadela and Dina Bass writing on Bloomberg.com on 5/17/11 in their piece "Hewlett-Packard Cuts Full-Year Forecasts as Consumers Hold Back Buying PCs," look at some eye opening statistics:

"The industry's shipments declined 3.2 percent last quarter, research firm IDC reported in April. Tablets will almost triple this year, IDC projected in January."

And tablets and smartphones is where Nvidia wants to be and it has made appropriate steps to get there. It sees a big pocket of opportunity.

Before we go on here, we need to backpedal a bit to the evolution of the semiconductor and to Jay Palmer's Barrons article as he explains the current state of the computer chip:

"The power and speed of a computer used to sit in its central processing unit...the brain of the device. No longer. Nowadays, the computer's GPU, or graphics processing unit, whether as a stand-alone chip or built-in next to the CPU, is every bit as important to performance, sometimes much more so."

To capitalize on this development, Nvidia recently, to much fanfare, released the Tegra chip, which essentially integrates the GPU with the CPU and is designed explicitly for mobile computing. It's catching on fast. In the recent conference call, Nvidia executives noted:

"Our Consumer Products business, which includes Tegra processors and embedded products achieved record revenue of over $122 million. The record performance is due to our first group of Tegra 2-based Android products hitting the market...based on market research from In-Stat, tablets represents the fastest-growing segment of mobile processors, with compound annual growth rate of 124% from 2009 to 2014. We continue to drive the lead role in the Android tablet market..."

I think the key word from that last paragraph is Android, which is Google's (NASDAQ:GOOG) operating system for smartphones. People tend to use Android in discussing Google's operating system for tablets too, but that is actually called Honeycomb. Whatever you want to call it, Google and Apple (NASDAQ:AAPL) are in a head-on collision when it comes to the inner workings of mobile devices. In fact, according to Fred Vogelstein in his recent article in WIRED Magazine "How the Android Ecosystem Threatens the iPhone," "In 2010, Android's share of smartphone sales exceeded Apple's for the first time." iPhone's smartphone market share is 15% where Android now commands 22%.

As a stock price, Nvidia has the potential to advance nicely with the competitive advantage in the Android space and is in bed with Google. CEO Jen-Hsun Huang commented about this relationship in the conference call:

"...we're working very closely with Google on Ice Cream Sandwich, and it's is a very important new generation of operating system based on starting from the Honeycomb base....so we're working very closely with the Google team, and Tegra will surely be wonderful for Ice Cream Sandwich when it comes."

When it gets here won't be for awhile, Q4 2011, but, besides the lucrative tablet space, there is still the smartphone sector, which continues to grow rapidly. CitiGroup analyst Glen Yeung comments on this in his 3/9/11 report:

"With smartphone units estimated to approach 650 million in 2014 (24% 3 year CAGR), competition in the apps processor space will be fierce. Kal-El, Nvidia's quad-core successor to Tegra 2 is currently sampling. We note Nvidia is nearly a year ahead of the competition, with quad-core chips from Qualcomm (QCOM) and Texas Instruments (NYSE:TXN) not expected to sample until 2012."

So what we can surmise here is that Nvidia chips could very well be to Android mobile devices what Intel (NASDAQ:INTC) semiconductors were to Microsoft's (NASDAQ:MSFT) Windows operating system. This could possibly mean that the boom and bust cycle for Nvidia's chips may not be as severe as in its previous incarnation of just a GPU vendor. And speaking of Intel, it's just entered into a new $1.5 billion, six-year cross licensing agreement with Nvidia and both parties are terminating all outstanding legal disputes, to paraphrase Lester Ratcliff in his 4/8/11 ValueLine report for Nvidia.

Consensus analyst earnings for the company as posted on Yahoo Finance are $1.04/share for this fiscal year ending in January 2012, and, $1.24 for the year after. At roughly $18 a share we get P/E Ratios of 17 for this year and 14.5 going forward. That's very respectable when you consider the potential market Nvidia is addressing. However, it should be noted that although earnings are increasing 60% in fiscal 2011, they are only projected to grow by 25% in fiscal 2012, so comparisons could get dicey. Nvidia encountered a similar situation during the previous quarter when it experienced a 1.7% drop in earnings and the stock paid the price, dropping almost 9% overnight.

With the introduction of the Tegra chip, there was a lot to like about Nvidia along with its already successful lines of GPUs. Since the company purchased Icera, it's a whole different dynamic. To quote Matthew Murray from PCMag.com again: "Icera has been granted, or has pending, more than 550 patents, and it's high speed wireless modem products are used by more than 50 carriers worldwide." Nvidia has expanded its revenue opportunity and that enables the company to reach a much broader market.

I don't mean to sound like a broken record, but I must reveal full disclosure in these postings and I am sitting in cash and have short positions in the S&P 500 (NYSEARCA:SPY) and the Russell 2000 via inverse ETFs. I've been wrong about the direction of the market for a year and a half, so you should take my investing decisions with a grain of salt. That said, I really like Nvidia. I've owned the stock before and plan to buy it again if the market drops down to more advantageous levels. For the time being, I am taking a pass on it along with all other equities. We haven't had a significant correction for some time and I'm just going to wait.

Disclosure: Am short the indexes with inverse ETFs.